Thursday, April 4th, 2019
Backing ASX large-cap turnarounds remains one of the most reliable investment strategies on the ASX and the latest example is Brambles, which is back to what it used to be and should have remained: a) an instigator and beneficiary of the conversion of fast-moving consumer goods manufacturers from single-use pallets to pooled, reusable pallets and b) a firm with mid-single digit global sales growth and able to reinvest earnings at returns on invested capital of 20 per cent. Finally, investors can have confidence in Brambles as a quality long-term investment, and the stock would be interesting below $11.50 in the next market correction. Our valuation is $12.55.
It has been a long and at times painful journey to this point. Investors with long memories will recall the ‘unpalatable’ disaster of 2000-03 when Brambles ‘lost’ nine million pallets after growing too quickly overseas without sufficient controls over the pallet inventory. Then there was the steep pre-GFC rally followed by an equally steep fall, then three years of sideways trading until mid-2012, then a strong rally to mid-2016, since when the stock has gone sideways with some volatility.
The rallies and disappointments have however been around a very long-term uptrend which goes back to the early 1980s when the stock traded as low as 37 cents. Over the last 39 years, the uptrend has priced in underlying value creation from the rollout of Brambles’ pooled pallets model to 64 countries from its Australian origins. This multi-decade trend is reassurance of what investors can continue to expect as the model’s penetration increases globally, especially in the US and emerging markets. In the first half of 2019 total volume growth was strong at five per cent as new and existing customers around the world sought the benefits of the share and re-use model across their supply chains.
Group sales revenue growth was seven per cent at constant currency, driven by this volume growth and higher prices in the pallets business. The price increases were an important response to the most recent disappointment for shareholders: margin compression from cost inflation in the US in 2018 as the costs of trucking (fuel and drivers) and lumber (to make pallets) surged with the country’s economic expansion. CHEP America’s earnings fell nine per cent despite six per cent growth in pallets sales revenue. There were also adverse changes in customer and retailer behaviour, inefficiencies from capacity constraints and higher pallet repair costs to meet quality standards.
In the first half of 2019 Brambles offset 75 per cent of the earlier inflationary cost increases in CHEP Americas with surcharges and contractual indexation clauses. ‘Never waste a good crisis’ the saying goes, and the gradual introduction of cost indexation clauses to customer contracts will increase earnings resilience the next time costs surge. We used to prefer Amcor for the existing industry pricing standards where increases in flexible packaging input costs are consistently passed on to customers but now Brambles is becoming similar, so we are happy owning it also.
We look to automation of pallet inspection processes as a path to sustained increases in CHEP Americas’ returns on capital over the next three to five years. ROCs in Europe are some six percentage points higher than in the Americas, partly because inspection processes there have already been automated.
The second half should see low single-digit earnings growth as the tail end of input cost inflation weighs, partly offset by progress at automation, productivity gains and supply chain efficiencies. Longer-term, shareholders can expect mid-single digit sales revenue growth, underlying profit growth faster than sales revenue growth from the progressive delivery of operating, organisational and capital efficiencies, and better returns on capital with self-funded growth. This is an impressive outlook for a large company.
Group return on capital improves with the sale of IFCO, whose first-half return on capital of 9.4 per cent was less than half of all the regional pallet divisions. We expect Brambles will return $1.95 billion of equity to shareholders in 2020, so return on equity gets a second boost as the equity base contracts.
We rate Brambles as one of the large companies least prone to technological disruption, as there are no emerging alternatives to shipping small consumer goods on wooden pallets. Plastic is too expensive and can’t easily be repaired and wood remains a cheap material for making pallets. It still costs US$20 to make a pallet – the same as 20 years ago. As Brambles raises its prices, there is the potential for underlying margin improvement.
Near term, Brambles’ European volumes are subdued by the region’s economic growth slowdown while volumes into the UK are higher as retailers stock up during uncertainty about customs and border arrangements post-Brexit. This will increase pallet cycle times and reduce operating cashflows for a while. Other downside risks are weaker volume growth, lack of traction from pricing/surcharge initiatives, and higher costs.
Amazon, by the way, is a net positive for Brambles because it typically returns pallets promptly, reducing their cycle times. Amazon also usually has only one distribution centre in each city, which makes collecting pallets faster.
Originally published in The Australian.